Withholding Under Code Sections 1446(a) and 1446(f)[1]
A partnership, such as a fund treated as a partnership for U.S. federal income tax purposes, that realizes income effectively connected with the conduct of a trade or business within the United States (“ECI”) is required to withhold tax against such ECI that is allocated to its non-U.S. partners.[2]
In addition, if any portion of the gain on disposition of a partnership interest by a non-U.S. partner is ECI, then the transferee of the interest must withhold 10% from the proceeds payable.[3] If the transferee fails to withhold the required amount, then the partnership must deduct and withhold from distributions to the transferee that amount in addition to interest.[4]
Exceptions to Withholding
Unless a transferee of a partnership interest establishes that the transferor is exempt from withholding, the transferee must withhold from the proceeds payable.[5] The transferee is not required to withhold when the transferee properly relies on a certification of exemption.[6] There are six exceptions to withholding.
- Transferor’s certification of U.S. status: The transferee may rely on a valid Form W-9.[7]
- Transferor’s certification of no realized gain: The transferee may rely on a certification from the transferor stating that the transfer of the fund interest would not result in realized gain to the transferor as of the determination date.[8] The determination date is (i) the date of transfer; (ii) any date that is no more than 60 days before the date of transfer; or (iii) the date that is the later of (a) the first day of the fund’s tax year in which the transfer occurs, or (b) the date of the most recent revaluation event before the date of the transfer.[9]
- The fund’s certification of less than 10% effectively connected gain: The transferee may rely on a certification from the fund stating that (i) if the fund sold all its assets at fair market value as of the determination date, then either (a) the amount of the fund’s net gain that is ECI would be less than 10% of the total net gain, or (b) the transferor’s distributive share of net gain that is ECI from the fund would be less than 10% of the transferor’s distributive share of the total net gain; or (ii) the fund was not engaged in a trade or business within the United States at any time during the tax year through the date of transfer.[10]
- Transferor’s certification of less than 10% ECI: The transferee may rely on a certification from the transferor stating that (i) the transferor was an investor in the fund throughout the look-back period (i.e., the transferor’s immediately prior tax year and the two preceding tax years); (ii) the transferor’s distributive share of gross ECI from the fund, as reported on a Schedule K-1 (Form 1065), was less than US$1m for each of the tax years within the look-back period; (iii) the transferor’s distributive share of gross ECI from the fund, as reported on a Schedule K-1, was less than 10% of the transferor’s total distributive share of gross income from the fund for each of the tax years within the look-back period; and (iv) the transferor’s distributive share of income or gain from the fund that is ECI and deductions or losses allocated to ECI have been timely reported on a federal income tax return and all amounts due have been paid.[11]
- Transferor’s certification of nonrecognition: The transferee may rely on a certification from the transferor stating that the transferor is not required to recognize gain or loss with respect to the transfer by reason of the operation of a nonrecognition provision of the Code. In the certification, the transferor must describe the transfer and relevant law and facts.[12]
- Transferor’s certification of tax treaty benefits: The transferee may rely on a Form W-8BEN (or Form W-8BEN-E if the transferor is an entity) from the transferor stating that the transferor is not subject to tax on gain from the transfer pursuant to an income tax treaty between the United States and another country. The transferee must mail a copy of the certification to the IRS within thirty days after the date of the transfer.[13]
The transferee must also certify to the partnership confirming the exemption to withholding, and the partnership is not required to withhold if the partnership relies on the certification received from the transferee.[14]
Partnership Admissions and Withdrawals
Investors and funds should be mindful of the potential for Section 1446(f) withholding on disguised sales of partnership interests and their additional compliance considerations.
Specifically, in the preamble to the final regulations, the Treasury acknowledged that a partnership admission (or withdrawal) could be treated as a “transfer” triggering withholding: “[i]f a contributing partner is treated as acquiring a partnership interest from a foreign person for Federal income tax purposes, it is appropriate to impose a withholding obligation on the contributing partner to ensure the collection of tax on gain under section 864(c)(8).”[15] In this regard, the regulations under Section 1446(f) broadly define a transfer: the term “transfer” means a “sale, exchange, or other disposition, and includes a distribution from a partnership to a partner, as well as a transfer treated as a sale or exchange under section 707(a)(2)(B).”[16] The Treasury issued proposed regulations under Section 707 on disguised sales of partnership interests, providing a presumption that an issuance and redemption made within two years of each other was a disguised sale.[17] The proposed regulations were withdrawn, and the Treasury and IRS continue to review the Section 707 regulations.[18]
In a typical term fund, when a new investor subscribes for a fund interest and pays a “late admission” fee, the fund usually treats such fee as a guaranteed payment to existing investors. Under this approach, there should not be a disguised sale of a partnership interest. However, there is a risk that the IRS might recharacterize the fees as sale proceeds potentially triggering Section 1446(f) withholding. Risk of recharacterization would appear even more problematic where the fund distributes the new investor’s capital to existing investors. Further, some fund partnership agreements recognize that a new admission should be treated as a disguised sale of a partnership interest.
In a typical evergreen fund, such as a hedge fund, investors are admitted and redeemed from the fund on a regular basis and at the same time. Disguised sale treatment is far more likely under such circumstances.
Because of the risk of withholding with partnership admissions and withdrawals, we expect that funds will adopt procedures to satisfy Section 1446(f)’s exceptions to withholdings with late closings and evergreen fund admissions and withdrawals.
[1] All “Section” references are to the United States Internal Revenue Code of 1986, as amended (the “Code”), or the Treasury Regulations promulgated thereunder (the “Treasury Regulations”), as applicable.
[2] Section 1446(a). In addition, a non-U.S. person is required to report any ECI on a U.S. federal income tax return and can claim any withholding as a refundable credit. Sections 871(b), 882(a).
[3] Section 1446(f)(1). Similar to allocations of ECI, the ECI on a sale of a partnership must be reported on a U.S. federal income tax return and any withholding can be claimed as a refundable credit. See Section 864(c)(8).
[4] Section 1446(f)(4). The withholding of tax by the partnership does not relieve the transferor from filing a U.S. federal income tax return with respect to the transfer or paying tax on gain of the transfer with the return that has not been fully satisfied through withholding. The transferor is not allowed a refundable credit for amounts withheld on distributions to the transferee. Section 1.1446(f)-3(e).
[5] Section 1446(f)(6).
[6] The transferee cannot rely on the certification if the transferee has actual knowledge that the certification is incorrect or unreliable. Section 1.1446(f)-2(b)(1).
[7] Section 1.1446(f)-2(b)(2).
[8] Section 1.1446(f)-2(b)(3) (realized gain includes ordinary income arising from Section 751).
[9] Section 1.1446(f)-1(c)(4).
[10] Section 1.1446(f)-2(b)(4).
[11] Section 1.1446(f)-2(b)(5). This exemption requires the partnership to issue Schedules K-1. If a fund does not issue Schedules K-1, which often arises with foreign funds, a transferor may have difficulty establishing an exemption.
[12] Section 1.1446(f)-2(b)(6), -2(c)(4)(v).
[13] Section 1.1446(f)-2(b)(7), -2(c)(4)(vi).
[14] Section 1.1446(f)-3(b).
[15] TD 9926, 85 Fed. Reg. 76,910, 76,915 (Nov. 30, 2020) (the final regulations).
[16] Section 1.1446(f)-1(b)(8) (emphasis added).
[17] REG-149519-03, 69 Fed. Reg. 68,838, 68,840 (Nov. 26, 2004).
[18] REG-149519-03, 74 Fed. Reg. 3,508, 3,509 (Jan. 21, 2009).
